Personal Finance

Prepayment vs home-loan transfer

Naveen Kukreja | Updated on October 07, 2018 Published on October 07, 2018

Before deciding, calculate the wealth creation potential of both options

Making loan prepayments, either in part or entirety, is a big temptation for most borrowers to reduce their EMI burden. This is especially true in case of long-term loans such as home loans where the interest component usually outstrips the principal component by a significant margin. More so, when the economy seems to be firmly in the grip of a rising-interest-rate scenario, and climbing EMIs start hurting disposable incomes.

While loan prepayments do save money, it may not be the most optimal thing to do, particularly for borrowers with a high risk appetite in investments. For such borrowers, transferring the home loan to another lender at a lower interest would generate more value than making prepayments.

When you make home-loan part-prepayments, you have two options to choose from — reduce your loan tenure while continuing with the existing EMI, or bring down your EMI with the same loan tenure.

For example, assume that you took a home loan of ₹30 lakh @ 10 per cent pa for a 20-year tenure two years ago. The current outstanding of your loan will be about ₹28.95 lakh with the EMI being ₹28,951. Now, if you choose to make a lump-sum prepayment of ₹4 lakh and continue with the existing EMI, you will save ₹14.33 lakh in interest payment and reduce your tenure by five years and three months. However, on choosing to reduce your EMI instead, your EMI will come down to ₹24,951 and save you ₹8.64 lakh over the remaining tenure. Thus, opting for tenure reduction will save you a bigger amount.

However, if you decide to transfer your home loan outstanding of ₹28.95 lakh to another lender @ 9 per cent for the remaining tenure, your EMI will come down to ₹27,114, generating a monthly saving of ₹1,837 and total savings of ₹3.96 lakh in the process. Thus, the savings generated through home-loan balance transfer (HLBT) will be substantially lower than making prepayments. But to arrive at a holistic decision, you need to factor in the opportunity cost of making prepayments and the wealth-creation potential of the monthly savings in the EMI amount.

Home-loan transfer

Although prepaying your home loans — especially by opting for a reduced tenure — will generate the highest savings, it has to be done by redeeming your existing or potential investments. This can adversely impact your financial health and involve a sizeable opportunity cost (the amount you could earn by investing elsewhere the amount used for prepayment). Instead, when you opt for HLBT, it still generates sizeable savings in interest cost without impacting your liquidity and existing investments. While the amount otherwise used for making prepayments will continue to generate returns, the savings in EMIs will also start generating returns on its own.

To make things clearer, let’s continue with the previous example. Now, if you invest the monthly savings of ₹1,800 in an equity fund SIP for 18 years, generating an annualised return of 12 per cent, you will have a corpus of ₹13.77 lakh.

Similarly, if the ₹4 lakh otherwise earmarked for prepayment is invested lump-sum in the same equity scheme, that in itself will create a corpus of ₹30.75 lakh and generate a wealth gain of ₹26.75 lakh at the end of 18 years. In our example, the amount of ₹26.75 lakh is the opportunity cost of making prepayment. The total wealth-creation potential from the HLBT option will be around ₹40.50 (13.77 + 26.75) lakh.

EMI reduction option

Now, let us find out the total benefit of opting for EMI reduction in prepayment. In our example, choosing the EMI reduction in prepayment reduced the EMI by ₹4,000. Investing the monthly savings in the same equity fund for 18 years will generate a corpus of ₹30.61 lakh.

While this option will exceed the opportunity cost of making prepayments by about ₹4 lakh, it falls short of beating the wealth-creation potential of HLBT by about ₹10 lakh.

Tenure reduction

Under this option, your savings will not be generates from reduced EMI, but from reduced tenure. As shown earlier in the example, your tenure will reduce by five year and three months on making a prepayment of ₹4 lakh.

If the original EMI amount is invested in the same equity schemes for the reduced tenure, you will create a corpus of ₹25.49 lakh at the end of the 18th year.

Thus, the wealth-creation potential in this case will fall short of the opportunity cost of making prepayments, ie ₹26.75 lakh. As far as total wealth-creation potential is concerned, HLBT beats prepayment (tenure reduction) by about ₹14 lakh.

Final take

When seen in isolation, making a lump-sum prepayment through the reduced tenure option would seem to generate the greatest savings in interest payout, followed by prepayments through reduced EMI. HLBT would seem to fare very poorly.

However, the situation reverses once you factor in the opportunity cost of making prepayments and the wealth-creation potential of reduced EMIs. Then, HLBT beats the two home-loan prepayment options by a wide margin.

The writer is CEO and co-founder of Paisabazaar.com

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